Learning little from Lehman

Wednesday

Sep 18, 2013 at 6:00 AM

By Peter S. Cohan WALL & MAIN

It’s just over five years since Lehman Brothers filed for bankruptcy, but it feels like just yesterday to me. Comments I have read on the topic suggest that we have learned important lessons – but it’s not clear what they are.

Until we wipe out the idea that some institutions are too big to fail and stop the heads-I-win, tails-you-lose compensation system that rules Wall Street, it’s a matter of time before another financial collapse becomes too big to bail out.

Five years ago, I remember clearly dropping my daughter off for her first day of college while trying to dodge phone calls from TV networks that wanted me to explain the collapse of Lehman Brothers and what it meant for the financial system. Another thing that remains fresh as a daisy in my mind is the fear I felt when I heard that a money market fund had broken the buck – meaning that the value of money market funds might evaporate along with the stock market value of the investment banks that perished in the financial crisis.

If my reading of America’s collective psyche is accurate, I think most people have put the financial crisis into the rear view mirror, and have decided not to look at it. But when I read what I wrote about the collapse of Lehman Brothers five years ago, it feels to me as though there is nothing to stop another crisis from happening.

That’s because in a March 15, 2008 blog post -- Is Lehman Brothers next? -- exactly six months before Lehman Brothers collapsed, I predicted that it would follow Bear Stearns in collapsing.

The day JPMorgan Chase scooped up the remains of Bear Stearns – losing 47 percent of its value – Lehman stock plunged more than any of its peers, nearly 15 percent. The problem with Bear and Lehman was that they borrowed way too much money -- $50 for every $1 of their capital – to load up their balance sheets with subprime mortgage backed securities. When their value plunged, their capital base was wiped out.

The way Bear Stearns failed is the same thing that happened half a year later at Lehman. Corporations, hedge funds and other investors withdrew the cash and securities the banks were holding to beat a bankruptcy filing. The reason for the race to the exits is clear enough: In bankruptcy, a customer’s cash and securities are controlled by a court which gets to decide which creditors will get their hands on those assets. The reason Bear Stearns failed is that its customers withdrew their funds so they would not be frozen by bankruptcy.

While Lehman was trying to calm the waters, investors were pulling their money out. Reuters wrote that Lehman held "extensive mortgage assets, and one credit derivatives dealer, speaking on condition of anonymity, said his bank was pulling back on its exposure to Lehman, as were his clients. Rumors of funds unwinding positions with Lehman abounded, with everybody from risk management consultants to hedge fund managers to traders having heard them."

While Lehman was bragging about how much more liquidity it had than Bear Stearns, the market for credit default swaps – that sells insurance of a bond issuer stops making interest and principal payments – put the lie to Lehman’s confidence. The CDS market concluded that Lehman was in much greater risk of going out of business. Reuters noted that "the cost of protecting Lehman's obligations against default for five years surged to 465 basis points, or $465,000 a year per $10 million protected, from $400,000 the day before."

Lehman’s collapse came close to wiping out the financial system. And were it not for the government’s decision to reverse itself and rescue American International Group the next week, the financial system would have collapsed. That means that banks would stop lending to each other and to companies and the companies would stop paying their bills – including salaries. Also, money market funds and possibly bank accounts would have become worthless.

I am glad to say that did not happen, because it is hard to imagine how society would have stayed together if it had. It seems to me that this kind of collapse would have forced people to grow their own food or kill and cook it – similar to the way I imagine people got by in the Stone Age.

While we’ve come a long way back in the last five years, we failed to put in place a mechanism for preventing a repeat performance. That’s because some institutions – like JPMorgan, Citigroup, and Goldman Sachs -- are considered too big to fail (TBTF). This means that if they get into mortal danger, the government will step in and bail them out. This creates an incentive for the biggest institutions to keep bulking up so nobody repeals their TBTF status

And debt-fueled financial crises keep costing more each time. The total bill – in cash and guarantees – for the bailout of the 2008 financial crisis was $23.7 trillion, according to Bloomberg. The next biggest government bailout was the S&L bailout in the early 1990s that cost about $220 billion, according to ProPublica.

The other thing that has not changed is the way bankers get paid. When they close deals, bankers get bonuses that are in proportion to the amount of money they make for the bank. That would be fine if the deals ended up making money in the long run. But the bankers don’t have to pay back their bonus if the deal ends up losing money for the bank, or the deal participants. The rational response to such an incentive system is to close big deals – regardless of how likely it is that they will go sour in the future.

I am sure there will be another financial crisis and that it will happen because of too much borrowing. And I am sure that bankers will keep doing these deals until they pay a personal price for disregarding risk during a period when their sales targets keep getting higher.

What I don’t know is whether the government will have sufficient resources to save the financial system the next time we have a financial crisis.

Peter Cohan of Marlboro heads a management consulting and venture capital firm, and teaches business strategy and entrepreneurship at Babson College. His email address is peter@petercohan.com.